Friday, 1 February 2013

What’s up with inflation?

Inflation has been given a bad name but
redemption may be at hand as high levels of debt mean developed economies could
benefit from more inflation.

Inflation has been
treated with the same disdain as smelly socks – an unfortunate factor of life
that is tolerable at low levels but too much may be the sign of something more
serious. This stems from periods in
history when inflation has wreaked havoc such as when hyperinflation in the
1930s in Germany resulted in prices skyrocketing to levels so high that Germans
would go grocery shopping with a wheelbarrow full of cash. Inflation eats away at the value of savings
with higher prices meaning that the same amount of money can no longer buy as
much. But the flip side of this is that
inflation also reduces the value of debt.
With the high level of debt among the most pressing concerns in many
developed economies, inflation no longer seem so bad and there has been a shift
in views that will affect anyone with savings or debt which is almost everyone.

The first signs of a
change came from the Federal Reserve which has two goals as the central bank of
the United States, low inflation and full employment. A focus on clamping down on inflation had
resulted in employment being less of a concern for the Federal Reserve, but as
central banks everywhere have been asked to help out with sluggish economic
growth, the Federal Reserve is paying closer attention to the job market in the
United States. In December, the Federal
Reserve announced that it would keep interest rates close to zero until
unemployment had fallen from its current level of 7.75% to 6.5% or until
inflation was forecast to top 2.5% which is higher than the target rate of
inflation of 2%. A key role of any
central bank is to signal its intentions so as to manage expectations for
inflation and the Federal Reserve has shown that it will be more tolerant of
inflation if that helps to lower unemployment.

More creative ideas on
monetary policy are coming from the newly appointed governor of the Bank of
England, Mark Carney. Carney achieved
almost rock star status after a successful spell (due to skill or good fortune)
as the governor of Canada’s central bank and his ideas are raising
eyebrows. Carney put forward the idea
that central banks should target nominal GDP instead of inflation. Typical GDP figures are quoted with the
effects of inflation taken out but nominal GDP includes both growth in the
economy and rising prices. This would
enable central banks to accept more inflation when the economic growth is slow
by setting interest rates to be lower (or monetary policy to be looser) than
would otherwise be the case. While this
new policy may be a bit too radial for the conservative world of central
bankers, it is a part of Carney’s belief that monetary policy can have more of
a role in lifting the economy out of the current stagnation and that there are
unconventional policies which could be implemented instead of monetary policy
simply aiming for a certain level of inflation.

More inflation will
also help governments with high levels of debt.
If prices rise at a faster rate, this will increase the size of the
economy in nominal terms and the amount of debt will shrink relative to the economy
making it easier to pay off. And it is
not only governments with lots of debt but many households who purchased
property during the housing boom are struggling with large mortgages and they
too should get some cheer from higher inflation for the same reason. Inflation will also been a boost to businesses
that will have more scope to raise prices and will be tempted to borrow more for
investment if interest rates are lower than inflation (also referred to as
negative real interest rates). But
inflation has always been the enemy of frugal types (including Your
Neighbourhood Economists) who have put money away and savers will be the big
losers. While it is unfair to penalise
the responsible, the burden of debt on governments and on the economy as a
whole in developed countries is currently so great that calls for more
tolerance of inflation should be heeded.
Inflation need not be so bad after all.